Knowledge Spillovers, Market Power and Innovation under Trade Shocks

Abstract

This paper examines how international trade shocks affect firm innovation when knowledge spillovers interact with market power. Using matched firm-patent data from China and the United States, I compare two opposite trade episodes-China's WTO accession and the 2018 U.S. trade war. I find that tariff reductions during liberalization increased innovation, whereas tariff increases under protection reduced it. The direction of these effects depends systematically on pre-existing spillover intensity: in China, sectors with stronger spillovers responded less to liberalization, while in the United States they experienced larger declines during protection. Firms with greater market share consistently exhibited stronger innovation responses in both settings. To explain these patterns, I develop a dynamic two-country model in which oligopolistic firms invest in R&D while knowledge flows among incumbents and to a competitive fringe. Calibrated counterfactuals show that modest, sector-specific R&D or competition-policy interventions can offset welfare losses at minimal fiscal cost.